Fed. Circ. Limits Gov't Contractors' Litigation Cost Claims

The U.S. Court of Appeals for the Federal Circuit's landmark decision in Geren v. Tecom Inc. in 2009 flipped decades of case law on its head and established the general rule governing the ability of contractors to recover costs of settling certain third-party litigation under government contracts.¹ In Bechtel National Inc. v. United States, the contractor sought to carve an exception from Tecom and potentially reverse the Tecom rule. Instead, the Federal Circuit doubled down on its prior decision.

In the July 16 Bechtel decision, the Federal Circuit affirmed the U.S. Court of Federal Claims' strict application of Tecom and rejected the argument that a Department of Energy contract clause providing for contractor recovery of litigation costs in some circumstances served as an exception to Tecom, notwithstanding regulatory history and prior course of dealing indicating that the parties intended such costs to be recoverable.

This case narrows the circumstances under which contractors may be able to carve out the Tecom standard through contract terms. And, unfortunately, the Federal Circuit declined to answer many of contractors' pressing questions about the reaffirmed Tecom test – leaving open the prospect of broader application.

Context: Allowability of Litigation Costs

The history of the allowability of litigation costs under government contracts is a convoluted one. For decades, third-party litigation costs, including those associated with cases involving alleged employment discrimination, were allowed as ordinary costs of doing business.² This position began to crumble in the early 2000s, and the Federal Circuit's Geren v. Tecom decision formalized the start of a new era.³

In Tecom, the Federal Circuit explained that "where neither the contract nor the [Federal Acquisition Regulation] dictates the treatment of specific costs, we must determine how those costs are to be treated by looking to the principles and standards in [FAR Section 31.204(c)] and the treatment of similar or related selected items."⁴

The circuit then announced a two-part test to govern when costs incurred by a contractor in defending and settling third-party claims – at least in the context of discrimination cases under Title VII of the Civil Rights Act – are allowable under a government contract:

(1) [W]e ask whether, if an adverse judgment [had been] reached, the damages, costs, and attorney's fees would be allowable; (2) if not, we ask whether the costs of settlement would be allowable.⁵

Tecom involved the costs of settling and defending a lawsuit alleging employment discrimination, and the contract at issue incorporated FAR 52.222-26 on equal opportunity. The circuit reasoned that, because an adverse judgment that the contractor had violated Title VII would breach the underlying contract, the costs of defending and settling such a lawsuit were unallowable – unless the contracting officer determined that the Title VII plaintiff had "very little likelihood of success on the merits."⁶ The circuit provided no insight into the meaning of "very little likelihood of success on the merits."

After Tecom, contractors were left in a quandary about the treatment of litigation expenses. Should the costs be segregated under FAR 31.205-47(g) pending resolution, as a successful defense would render the costs allowable, and resolution through settlement would be unknowable at commencement of a case? Would the standard apply only to Title VII litigation or to all third-party litigation? What would be sufficient to demonstrate that the plaintiff would have "very little likelihood of success on the merits?" And, so on.

Bechtel: Prior Proceedings

The Bechtel case involved allowability of costs associated with two discrimination lawsuits brought by former employees on a contract that included FAR 52.222-26 on equal opportunity. The contracting officer reviewed the claims and issued a final decision disallowing the contractor's costs associated with defending the cases, citing Tecom.

The contractor appealed, arguing that because the underlying contract included a specific DOE Acquisition Regulation, or DEAR, speaking to the allowability of litigation costs,⁷ that the Federal Circuit's two-part test from Tecom should not apply. Specifically, Bechtel invoked the qualifying language from Tecom suggesting that its two-part test only applies "where neither the contract nor the FAR dictates the treatment of specific costs."

There was no challenge to the contracting officer's determination with respect to the likelihood on the merits of the third-party claims. U.S. Court of Federal Claims Judge Elaine Kaplan rejected this argument, finding the settlement costs unallowable under Tecom.⁸

Appeal to the Federal Circuit

Bechtel appealed, arguing primarily that the Court of Federal Claims improperly applied the Tecom standard on the basis that the DOE clause provided for the allowability of the costs at issue. Bechtel argued that the regulatory history of the DOE clause and the parties' prior course of conduct showed that DOE intended to assume the risk of reimbursing costs associated with defending against third-party claims. Bechtel further argued that, in the event the Tecom standard did apply, the Federal Circuit should revisit Tecom en banc to clarify the scope of its holding.

The circuit affirmed by a unanimous opinion by U.S. Circuit Judge Pauline Newman, in which Judges Alvin Schall and Timothy Dyk (author of the Tecom majority opinion) joined. The circuit acknowledged that: "Tecom recognized that the analysis for determining whether the costs are allowable could change if there was a contract provision 'dictat[ing] the treatment of specific costs.'"⁹

But the circuit concluded that the DEAR provision at issue does not qualify, because while the DEAR clause "generally provides for reimbursement," it only does so "subject to certain exceptions," including where other provisions of the contract disallow the costs in question.¹⁰

Because the same FAR clauses at issue in Tecom appeared in the DOE contract at issue here, FAR 31.204 and 52.222-26, they serve this role.¹¹ The circuit concluded that because the contractor abandoned its arguments regarding the "little likelihood of success on the merits" prong of the Tecom test, the defense costs are unallowable.¹²

The panel also reemphasized and restated that one of the underlying rationales for the Tecom standard is the view that "'pass[ing] such costs on to the government in a contract context' would be contrary to public policy under the [U.S.] Supreme Court's decision in [National Association for the Advancement of Colored People v. Federal Power Commission]."¹³ This holding suggests that the prospect of wrongdoing was a driving factor in Tecom and the assessment of cost allowability.

The panel concluded that, as a prior precedential decision, it is "bound by Tecom," and noted that the contractor "has not demonstrated that Tecom is in any way unsound such that the panel should recommend en banc review pursuant to Federal Circuit Rule 35."¹⁴

Lessons Learned

Bechtel serves as a wholehearted reaffirmation of the Tecom standard, and a narrowing of the potential for contractors to sidestep the Tecom standard by pointing to express contract provisions and prior course of dealing indicating an agency's willingness to reimburse litigation expenses associated with defending against third-party claims.

Open issues remain, in particular with respect to how explicit a contract provision must be to avoid the Tecom standard. More broadly, the circuit also declined to address whether Tecom may be applied to litigation defense and settlement costs outside of the employment discrimination context – for example, those associated with general breach of contract allegations – despite considerable debate between the parties on this point.¹⁵

And because the contractor did not pursue the issue on appeal, the decision leaves unanswered the critically important question of what is sufficient to demonstrate the "very little likelihood of success on the merits" standard. Contractors are therefore still without any guidance regarding this primary avenue through which the cost of defending or settling a third-party lawsuit may be allowable costs under government contracts.

The Bechtel decision is not encouraging to any who hoped the Federal Circuit might be willing to rein in Tecom. Unlike Tecom, which was a 2-1 decision with a substantial and reasoned dissent, Bechtel is unanimous. Although the Federal Circuit decision to rehear a case en banc is not dependent on any recommendation from the merits panel, the panel judges have clearly indicated they are unlikely to vote in favor of or encourage en banc review of Tecom. If Bechtel files a petition for en banc review, the court's consideration may be guided by any amici curae that decide to weigh in.

In sum, Bechtel reaffirms that Tecom is the law of the land and narrows at least one possible avenue around application of the Tecom standard. Short of en banc action, if contractors want this standard to change, regulatory or statutory action will likely be the only way around the Federal Circuit's established test.